Designating Votes: Selfish Informed Self Interest v. Untoward Advantage

Pacific Western Bank v. Fagerdala USA-Lompoc, Inc. (In re Fagerdala USA-Lompoc, Inc.), 891 F.3d 848 (9th Cir. 2018) –

A secured creditor sought to block a Chapter 11 plan of reorganization by purchasing claims from some of the creditors in the general unsecured creditor class. At the debtor’s request, the bankruptcy court designated the votes of the purchased claims under section 1126(e) of the Bankruptcy Code. The district court affirmed and the secured creditor appealed to the Ninth Circuit.

The secured creditor held a claim of ~$4 million secured by property worth ~$6 million. In other words, the secured creditor did not have a deficiency claim, and thus the debtor did not have to deal with trying to separately classify the secured creditor’s deficiency claim and the claims of the general unsecured creditors. The secured creditor claim was placed in one class and the general unsecured claims were placed in another class. All claims were deemed impaired.

In order to obtain confirmation, the debtor needed approval by the general unsecured class to satisfy the confirmation requirement that at least one class of impaired claims approve the plan. Approval by a class requires that the plan be accepted by claims representing a majority in number and two thirds in amount of all claims in the class. So, to prevent the general unsecured class from becoming the required accepting class, the secured creditor purchased some of the general unsecured claims. Ultimately it acquired more than half of the claims in number representing only 10% in amount (~$13,000) – which was sufficient to block approval by the class.

Section 1126(e) provides: “On request of a party in interest … the court may designate any entity whose acceptance or rejection of such plan was not in good faith ….” The debtor moved to designate the purchased claims on the grounds that they were not acquired in good faith. The bankruptcy court’s focus was on whether the secured creditor offered to buy all claims are just a few. The secured creditor conceded that it did not attempt to buy every claim but argued there were good reasons for its choice. However, the bankruptcy court decided as a matter of law that it was not going to consider the creditor’s motivation.

The bankruptcy court conceded that good faith did not require selfless disinterest, so obtaining a blocking position was not per se bad faith. “However, a creditor’s conduct in further [sic] of its own interest should not result in an unfair disadvantage to other creditors.” In the court’s view, allowing the creditor to block the plan based on purchasing only a small amount of the debt was “highly prejudicial” to the remaining unsecured creditors who did not receive an offer, which justified designation.

In other words, designation was based on (1) the secured creditor did not make an offer to all unsecured creditors, and (2) this gave the secured creditor on “unfair advantage.” On appeal the Ninth Circuit found that these two facts were not sufficient for a finding of bad faith.

After noting that good faith is a fluid concept and “no single factor can be said to inexorably demand an ultimate result” the court articulated general principles as follows (citations omitted):

Generally, §1126(e) “appl[ies] to those who were not attempting to protect their own proper interests, but who were, instead, attempting to obtain some benefit to which they were not entitled.” An entity acts in bad faith when it “seeks to secure some untoward advantage over other creditors for some ulterior purpose.”

… [B]ad faith explicitly does not include “enlightened self interest, even if it appears selfish to those who do not benefit from it.” It is always necessary to keep in mind the difference between a creditor’s self interest as a creditor and a motive which is ulterior to the purpose of protecting a creditor’s interest.… [P]urchasing … claims for the very purpose of blocking confirmation of… [a] proposed plan is not to be condemned.”

Turning to the specifics of the case, the court disagreed with the proposition that failing to make an offer to purchase all claims in a class was sufficient to show bad faith. The court reasoned that (1) purchasing claims to secure the approval or rejection of a plan was not by itself bad faith, (2) blocking a plan required only a numerical majority of claims, not the entire class, and (3) taking action permitted under the Bankruptcy Code and case law without evidence of an ulterior motive cannot be bad faith. So, while offering to purchase all claims in the class might be a factor favoring a finding of good faith, failing to do so did not establish bad faith.

With respect to the bankruptcy court’s finding of unfair advantage, the Ninth Circuit held that the focus should be on the motivation of the creditor, not solely the negative effect on other creditors. The critical question is whether the creditor is attempting to obtain a benefit that it was not entitled to. Classic examples include: an entity that was not a creditor buying claims so that it can block actions against itself, a competitor buying claims to destroy the debtor’s business for its own benefit, and the debtor arranging to have an insider purchase claims.

In this case the secured creditor was purchasing claims so that it could block the plan for the legitimate purpose of protecting its own interests. Accordingly, the Ninth Circuit reversed the district court and vacated the bankruptcy court order.

This issue can be particularly relevant in real estate cases. Even if the secured creditor is not underwater (thus raising the question of proper classification of the deficiency claim), it is frequently the case that its claim is substantially larger than all of the other claims combined. In that circumstance purchasing claims becomes a feasible and economically attractive way to prevent a cramdown. In this particular case, if you ignore the costs of litigating the designation issue, the secured creditor was able to protect a $4 million claim by spending $13,000. Of course, the test for designation may depend upon the jurisdiction and the cost of litigating can be far from trivial.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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